Costs of Financial Distress - Wharton Finance



Costs of Financial Distress

16.1 Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60% and a recession is 40%. It is projected that Good Time will generate a total cash flow of $250 million in a boom year and $100 million in a recession. The firm’s required debt payment at the end of the year is $150 million. The market value of Good Time’s outstanding debt is $108.93 million. Assume a one-period model, risk neutrality, and an annual discount rate of 12% for both the firm’s debt and equity. Good Time pays no taxes.

a. What is the value of the firm’s equity?

b. What is the promised return on Good Time’s debt?

c. What is the value of the firm?

d. How much would Good Time’s debt be worth if there were no bankruptcy costs?

e. What payoff, after bankruptcy costs, do bondholders expect to receive in the event of a recession?

f. What cost do bondholders expect Good Time to incur should bankruptcy arise at the end of the year?

16.2 Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of a recession next year is 20% and the probability of a continuation of the current expansion is 80%. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $0.8 million. Steinberg’s debt obligation requires the firm to pay $750,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a one-period model, risk neutrality, and an annual discount rate of 15%.

a. Assuming there are no costs of bankruptcy, what is the market value of each firm’s debt and equity?

b. What is the value of each firm?

c. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?

3. What are the direct and indirect costs of bankruptcy? Briefly explain each.

4. “A firm’s stockholders will never want the firm to invest in projects with negative net present values.”

Do you agree or disagree with this statement. Explain your answer.

5. Due to large losses incurred in the past several years, a firm has $2 billion in tax-loss carry-forwards. This means that the next $2 billion of the firm’s income will be free from corporate income taxes. Security analysts estimate that it will take many years for the firm to generate $2 billion in earnings. The firm has a moderate amount of debt in its capital structure. The firm’s CEO is deciding whether to issue debt or equity in order to raise the funds needed to finance an upcoming project. Which method of financing would you recommend? Explain.

6. Fountain Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm’s only activity and that the firm will close one year from today. Fountain is obligated to make a $500 payment to bondholders at the end of the year. Assume the firm’s stockholders are risk-neutral. Consider the following information pertaining to the two projects:

a. What is the expected value of the firm if the low-risk project is undertaken? What if the high-risk project is undertaken? Which of the two strategies maximizes the expected value of the firm?

b. What is the expected value of the firm’s equity if the low-risk project is undertaken? What if the high-risk project is undertaken?

c. Which project do Fountain’s stockholders prefer? Explain.

d. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high-risk project. To minimize this agency cost, the firm’s bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountainhead chooses to take on the high-risk project. By how much would bondholders need to raise the debt payment so that stockholders would be indifferent between the two projects?.

16.7 What measures can stockholders undertake to minimize the costs of debt?

16.8 How do the existence of financial distress costs and agency costs affect Modigliani and Miller’s theory in a world where corporations pay taxes?

9. What are the sources of the agency costs of equity?

Personal Taxes

10. Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual 10% debt. The firm will use the proceeds of the bond sale to repurchase equity. Fortune distributes all earnings available to stockholders immediately as dividends. The firm will generate $3 million of earnings before interest and taxes (EBIT) every year into perpetuity. Fortune is subject to a corporate tax rate of 40%. Financial information for the firm under each of its two possible financial structures is shown below:

a. Suppose the personal tax rate on interest income (TB) and equity distributions (TS) is 30%.

i. Which plan do equity holders prefer?

ii. Which plan does the IRS prefer?

iii. Suppose equity holders demand a 20% return after personal taxes on the firm’s unlevered equity. What is the value of the firm under each plan?

b. Suppose TB = 0.55 and TS = 0.20.

i. What is the annual after-tax cash flow to equity holders under each plan?

ii. What is the annual after-tax cash flow to debt holders under each plan?

11. When bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions (TS) equals zero is:

VL = VU + [ 1 – {(1 – TC) / (1 - TB)}] * B – C(B)

where VL = the value of a levered firm

VU = the value of an unlevered firm

B = the market value of the firm’s debt

TC = the tax rate on corporate income

TB = the personal tax rate on interest income

C(B) = the present value of the costs of financial distress

Assume all investors are risk-neutral.

a. In their no tax model, what do Modigliani and Miller assume about TC, TB and C(B)? What do these assumptions imply about a firm’s optimal debt-equity ratio?

b. In their model with corporate taxes, what do Modigliani and Miller assume about TC, TB and C(B)? What do these assumptions imply about a firm’s optimal debt-equity ratio?

c. Consider an all-equity firm that is certain to be able to use interest deductions to reduce its corporate tax bill. If the corporate tax rate is 34%, the personal tax rate on interest income is 20%, and there are no costs of financial distress, by how much will the value of the firm change if it issues $1 million in debt and used the proceeds to repurchase equity?

d. Consider another all-equity firm that does not pay taxes due to large tax-loss carry-forwards from previous years. The personal tax rate on interest income is 20%, and there are no costs of financial distress. What would be the change in the value of this firm from adding $1 of perpetual debt rather than $1 of equity?

12. Overnight Publishing Company (OPC) has $2 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is held by one institution that is willing to sell it back to OPC for $2 million. The institution will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,100,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 35%, and the required rate of return on the firm’s unlevered equity (r0) is 20%. The personal tax rate on interest income (TB) is 25% and the personal tax rate on equity distributions (TS) is 10%. Ignore bankruptcy costs.

a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?

b. What is the value of OPC if decides to repurchase stock instead of retire its debt?

13. Frodo, Inc., is an all-equity firm with 1,000 shares of common stock outstanding. Investors require a 20% return on Frodo’s unlevered equity. The company distributes all of its earnings to equity holders as dividends at the end of each year. Frodo estimates that its annual earnings before interest and taxes (EBIT) will be $1,000, $2,000, or $4,200 with probabilities of 0.1, 0.4, and 0.5, respectively. The firm’s expectations about earnings will be unchanged in perpetuity. There are no corporate or personal taxes.

a. What is the value of the firm?

b. Suppose Frodo issues $7,500 of debt at an interest rate of 10% and uses the proceeds to repurchase 500 shares of common stock.

i. What is the new value of the firm?

ii. What is the new value of the firm’s equity?

iii. What is the required return on the firm’s levered equity?

iv. What is the firm’s weighted average cost of capital?

c. Suppose that Frodo’s earnings are subject to a corporate tax rate of 40%.

i. Will the presence of corporate taxes increase or decrease the value of the firm? Why?

ii. What is the value of the firm?

d. Suppose that, in addition to a tax on corporate income of 40%, interest income is taxed at 35% and the effective tax rate on equity is 15%. Assume that the introduction of the personal tax rate does not affect the required return on the firm’s equity. What is the value of Frodo in a world with personal and corporate taxes?

14. Mueller Brewing Company is an all-equity firm that has been ordered by the EPA to stop polluting a local river. It must now spend $100 million on pollution-control equipment. The company has three alternatives for obtaining the needed $100 million:

1. Sell $100 million of perpetual, corporate bonds with a 20% coupon payable at the end of every year. Interest income on these bonds is subject to a personal tax rate of 15%.

2. Sell $100 million of perpetual pollution-control bonds with a 17% coupon payable at the end of every year. The interest on these bonds is not taxable to investors.

3. Sell $100 million of common stock with a 9.5% current dividend yield.

Mueller Brewing Company is subject to a corporate tax rate of 35%. Equity distributions are not taxable to investors. The president of Mueller wants to sell common stock because it carries the lowest rate. Mr. Daniels, the company’s treasurer, suggests bond financing because of the tax shield offered by the debt. His analysis shows that the value of the firm would increase by $35 million (= 0.35 * $100 million) if Mueller issues debt instead of equity. A newly hired financial analyst, Ms. Henderson, agrees with Mr. Daniels and adds that it does not matter which type of debt is issued since the yields will be bid up to reflect taxes.

a. Comment on the analyses of the president, Mr. Daniels, and Ms. Henderson.

b. Should Mueller be indifferent about which financing plan it chooses? If not, rank the three alternatives and give the benefits and cost of each.

16.15 Sid Whitehead, CEO of the Weinberg Corporation, is evaluating his firm’s capital structure. He expects that Weinberg will have perpetual earnings before interest and taxes of $800,000. The after-tax required return on Weinberg’s equity if it were an all-equity firm is 10%. Currently, the firm has $1.2 million in debt outstanding and is subject to a corporate tax rate of 35%. The personal tax rate on interest income is 15%, and the personal tax rate on equity distributions is zero. The combined financial distress and agency costs associated with the debt are approximately 5% of the total value of the debt.

a. What is the value of the firm?

b. What is the added value of Weinberg’s debt?

16.16 New England Textile Corporation (NETC) has decided to relocate to North Carolina in four years. Because of transportation costs and a non-existent secondary market for used textile machines, all of NETC’s machines will be worthless after four years. Mr. Rayon, a plant engineer, recommends that one of the following two machines should be purchased for use in the existing plant over the next four years:

The machines will be depreciated on a straight-line basis. NETC is subject to a corporate tax rate of 34%. NETC obtained the following information for its analysis of various investments and financial proposals:

NETC, an all-equity firm, has a market value of $10 million.

a. What is NETC’s cost of capital?

b. Which of the two machines should NETC purchase?

c. The CFO of NETC is considering the sale of $2 million of 10% perpetual bonds and using the proceeds to repurchase NETC stock. If this plan is adopted:

i. What is the new value of the firm?

ii. What is the value of the firm’s equity?

d. Suppose that, because of the new debt, the firm will face costs associated with possible financial distress. These costs can be expressed as 2% of the levered firm value calculated in part c. Do these costs imply that NETC should remain unlevered?

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